How Bad Credit Could Be Doubling Your Car Insurance Bill

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You've probably heard by now that in some vague way, your credit rating has something to do with the premiums your auto insurance company charges you for coverage. But if you're like me, you've probably never quite understood the details of how this work.

Fortunately, the good folks at InsuranceQuotes.com -- a subsidiary of Bankrate (RATE) -- recently published a report that draws back the curtain on this little-understood quirk of the insurance industry.

Blame it on FICO

Used to be, the rate you paid for insuring your car was tied primarily to demographic and personal factors that were clearly connected to the risk that you'd damage your car and ask the insurance company to pay for it: things like your age, sex, marital status, and driving history. It won't surprise anyone that younger, unmarried men are more likely to be risky drivers than soccer moms, and should therefore pay higher premiums. But about 20 years ago, the folks at Fair Isaac Corporation (FICO) found a correlation between low credit scores and a higher risk of filing an insurance claim.

That's not causation, of course -- having bad credit doesn't somehow cause you to crash your car. But according to FICO, "people who choose to effectively manage their finances are also less likely to have future insurance losses." Conversely, there is a "statistical correlation between a person's credit score and the likelihood that he or she will file an auto insurance claim in the future."

Shazzam! Suddenly, FICO had a new way to hawk its credit histories to insurance companies -- and insurance companies had a new excuse to raise your rates.

News Flash: Everybody Does It

Ever since, insurance companies have used this finding to tweak the rates they charge you for insurance. Today, says InsuranceQuotes, "about 97 percent of U.S. insurance companies" do it.

But how do they do it, exactly?

InsuranceQuotes.com wanted to find out, and so they ran some tests, requesting quotes for a hypothetical insurance customer with the following attributes:

Age: 45

Sex: Female

Marital status: Single

Accident history: No prior claims

Insurance history: No lapses in coverage.

In essence, InsuranceQuotes started with the perfect candidate. Neither too young, nor too male, to be considered an unsafe driver. Spotless driving history. Just the person you'd expect an insurance company to consider low-risk and to offer a low insurance rate. Now let's see what happens to her rates as her credit history changes.

Excellent "credit-based insurance score" (not the same as a FICO credit score): No effect

Median score: Premium goes up by 24 percent

Poor score: Premium goes up by 91 percent

Ignorance Is Not Bliss

As you can see, there's some pretty serious coin at stake here. Yet according to a 2005 report out of the Government Accountability Office, roughly two-thirds of consumers surveyed had no idea that their credit rating could affect their insurance rates at all -- much less cost them nearly double for poor credit.

It literally pays to know the truth about this. And the truth is that if you're among the two-thirds who don't know the details of how insurance companies use credit history to determine your rate -- and if you're a customer of one of the 97 percent of companies that engage in this practice -- you're probably paying through the nose for your ignorance.

Let's Fix That

What do we know about how this system works? Not a lot.

Individual insurance companies hold information about their pricing practices close to the vest, calling their methods for setting rates trade secrets. Worse, according to Former Texas Insurance Commissioner Bob Hunter, now director of insurance at the D.C.-based Consumer Federation of America, "every insurance company uses this score differently."

But there are some general rules that appear to hold true across the industry.

FICO insurance underwriting expert Lamont Boyd tells InsuranceQuotes.com that just two factors make up about 70 percent of the credit-based insurance score that insurers use in setting their rates. Specifically:

30 percent of your score depends on "how much credit card and loan debt you have compared to how much you are allowed to borrow."

Even more important, "40 percent of every consumer's bottom line score will be driven primarily by whether or not you paid your credit obligations on time."

Other inputs include length of credit history, collections, bankruptcies, and new applications for credit.

Knowledge Is Power

Knowing this, we can suggest a couple of simple rules that will -- if not necessarily protect you from this insurance industry practice -- at least help to minimize your risk of getting gouged.

First rule: Don't max out your cards, and always make sure you have lots of credit available to you. That means not necessarily closing credit card accounts just because you don't need the cards anymore (which would decrease your available credit, even as it risks removing beneficial, long-held credit accounts). The key is to have a lot of cushion between the amount you actually owe and the ceiling on your credit limit.

Second rule: Pay your bills on time.

Extreme option: If all else fails, you could move to California, Hawaii, or Massachusetts. According to InsuranceQuotes.com, these three states are the only states that ban the practice of setting insurance rates based on credit ratings. (Although two of those states have other downsides: In a state-by-state rundown of most expensive average car insurance costs, California came at No. 7, and Hawaii at No. 15. But Massachusetts falls in the bottom third, price-wise, at No. 35.)

Motley Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.